Previously, Barclays was bearish on the entire Agency mREIT sector, leaving every Buy rating downgraded. Now, analysts at Barclays have come out with their estimates and expectations about what your favorite mortgage REIT might disclose at the end of the second quarter. This article attempts to present those estimates and determine which is the best positioned Agency-only mREIT.
The second quarter was overshadowed with concerns about the unwinding of QE3. The markets have already started pricing in the effect of the eventual halt of the easing, and as a result, investors can see wider MBS spreads and higher yields. Overall, the sell-off within the Agency mREIT space continued across the board with 15-year fixed rate residential Agency MBS holding up better than the 30-year fixed rate Agency paper.
While the widening of the Agency MBS spread continued to pose a risk for book values in the near-term, the long-term perspective is bright. That’s because in the longer-term, this wide spread would translate into higher returns as mREITs deploy more capital into new production high yielding MBS. Analysts at Barclays also believe that if the MBS spread continues to widen, hybrids should be preferred over their Agency-only counterparts.
Incremental return from forward settling markets
Analysts at Barclays believe American Capital Agency Corp. (NASDAQ:AGNC) will benefit the most from incremental returns from forward settling markets with an upside if the spreads remain elevated and the company deploys more capital into new production MBS with high yields.
Overall, you can expect interest income that is below the first quarter levels and interest expense that is significantly above the prior level, causing the net interest income to decline over the linked quarter. This should cause core income to decline over the same time period. Analysts at Barclays expect American Capital Agency Corp. (NASDAQ:AGNC) to announce a book value decline of as much as 11.5% during the second quarter.
Increased hedging cost
ARMOUR Residential REIT, Inc. (NYSE:ARR) is another pure-play mREIT for which analysts at Barclays are not bullish. They believe its net interest spread will take a modest hit due to increased hedging costs during the quarter. Like American Capital Agency Corp. (NASDAQ:AGNC), ARMOUR Residential REIT, Inc. (NYSE:ARR) will require more time to take advantage of the prevailing wider spreads. However, it’s current monthly dividend distribution of $0.07 per share is viewed as sustainable by Barclays. You should expect significant downside if the company decides to sell large chunks of its assets to avoid adding more leverage as book value declined.
Given the company’s high concentration in the low-coupon and longer duration (30-year) securities, its book value is estimated to decline by 15% over the prior quarter, while the net interest income could surge as much as 18%.
Net interest rate spread widening
Annaly Capital Management, Inc. (NYSE:NLY), the largest mREIT, will be one of the very few mREITs that Barclays expect to report a wider net interest rate spread during the second quarter. During the first quarter, Annaly Capital Management, Inc. (NYSE:NLY) sold nearly $17.2 billion worth of Agency MBS at a lower average yield, and also decreased its cost of funds. A combination of these factors is expected to lead to the wider spread. Further, its bottom line will also benefit from the accretion of its recent CreXus acquisition.
Despite a heavy reliance on the 30-year fixed rate residential Agency MBS, the company is expected to report 10% decrease in its book value. This is still lower than American Capital Agency Corp. (NASDAQ:AGNC) and ARMOUR Residential REIT, Inc. (NYSE:ARR).
CYS Investments Inc (NYSE:CYS) is another Agency-only mREIT. However, the nature of its investment portfolio is very different from that of the aforementioned mREITs. Besides owning fixed rate MBS, CYS Investments Inc (NYSE:CYS) has investments in hybrid adjustable-rate MBS. These are securities for which the interest payment is fixed for an initial period and thereafter resets as it does on the adjustable-rate MBS. The company has a higher concentration (51% of its portfolio) in the 15-year and 20-year fixed rate Agency paper, which is why its book value should experience comparatively less decline. Barclays expects the company to report a book value decline of 10%.
Barclays believes that CYS Investments has benefitted from wider spreads during the second half of the first quarter and during the entire second quarter. Further, the company’s participation in forward settling market should provide it with additional returns. Therefore, analysts expect a wider net interest rate spread with an upside in dividends.
Conclusion
Given the uncertainty around the unwinding of QE3 and the widening of the spreads, Barclays is bearish on the Agency mREIT space. However, I believe Annaly Capital Management, Inc. (NYSE:NLY) and CYS Investments are better positioned to outmaneuver the prevailing challenges. Besides, further widening in the spreads could mean an upside for their investors. Therefore, I recommend investors buy Annaly Capital Management, Inc. (NYSE:NLY) and CYS Investments.
The article What Barclays Expects From Your Agency mREIT originally appeared on Fool.com and is written by Adnan Khan.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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